JAMES P. WESTON: Hi. Welcome back to finance for non-finance professionals. This week we've been talking about measuring cash creation and cash flow through the financial statements. In this short lesson, we're going to walk through a calculation of free cash flows and we're going to take that through to what we would do with it by circling back to the lessons that we did in week one and two. So our measure of free cash flow operating profit after tax, less any increase in working capital, plus depreciation, subtracting off any capital expenditures, and adding back any after tax salvage value. What we're going to do with that measure of free cash flow is go back to week two and construct a net present value, internal rate of return, payback period. All the capital budgeting tools that we learned in week two, we're going to now use the free cash flow analysis to go back and circle back to our measures of capital budgeting. So let's go to a spreadsheet, and let's work through the example that we did in the previous lesson, and calculate some of our capital budgeting tools. OK. So here's a really simple spreadsheet that contains the example that we did in the previous lesson about constructing free cash flows. So let's go back and first off reconstruct free cash flows. In period zero, we had nothing going on in the income statement, because we haven't had a full year for the flow yet. But we did have a spending of $500. So I'm going to put that in as a subtraction. I subtract $500 CAPEX. And then I'm going to subtract the increase of $150, because really I'm going from $0 to $150 in order to start the project. It's like I'm investing $150 of working capital. So my total spending is $650. So $650 in spending. Now let's go back in the following years and construct free cash flow in each period. And that's going to be my net operating profit after tax. I'm going to subtract any increase in working capital. So that's going to be from $100 minus the previous working capital of $150. And then I'm going to add back depreciation, because that money never really left. I'm going to subtract any capital expenditures from capital spending. There's nothing there, but I'll subtract it anyway for completeness. And then I'm going to add back any asset sales or terminal values. Again, there won't be anything until the end, but I'll add it in and each formula for completeness. OK. So there's my free cash flow calculation. And that comes out to $220. And then I'm just going to Control C, copy, and then paste that in each period. So that generates $220 in free cash flow in period one, $220 in free cash flow in period two, and $420 in free cash flow in period three. The extra $200 in period three comes from the fact that I'm sweeping clean the balance sheet by getting rid of the assets that I had left on the balance sheet. I had a net property plant and equipment of $200. I'm getting rid of it by selling it. That's generating the extra $200 in free cash flow. OK. So now we can go through and calculate the net present value. How are we going to do that? Well the one thing that we can do is just follow the formula. And that's minus the initial investment-- it's already a minus. So 650. Then I'm going to say plus what-- $220, my period one cash flow. And what am I going to do? I'm going to discount it by my discount rate up here-- 10%, and then add on my second period cash flow and discount that by 1 plus 10% raised to two, two periods out, and then add on my third period free cash flow, and discount that. 1 plus 10% raise to three per. And there's my net present value formula in Excel. When I hit Return, $47.37. So positive NPV. That capital budgeting tool says do the project. There's an easier way to do this in Excel, which is using the NPV formula. If I just say equals NPV-- and most spreadsheet programs have this formula built into them. It knows what to do. It says what rate are you using? I go and get 10%. And then it says what are your values. I go and I grab and I highlight all my future cash flows. All I need to do now is tag on my initial cash flow and NPV does the rest of the work for me. Oops, that's in percent. Let's format that right. There. And I get the same answer using the formula. That's a nice easier way to do it. IRR-- what's my internal rate of return on the project? Well, that's easy in Excel or any spreadsheet program. I can just say equals IRR, and go and get my cash flows. And the spreadsheet, like we talked about, is going to solve that for me. Whoops. Let's put that in percentage terms. There it is. Great. 14% IRR. To calculate the payback I'm just going to go ahead and calculate the cash flows, and then I'm going to add back the previous cash flow, and then add on the current cash flow. And let's see when that turns positive. So it doesn't pay back in a year. It doesn't pay back in two years. But it pays back sometime during year three. I could also calculate a return on invested capital. If you remember that from our capital budgeting tools, that was average forecasted profit, divided by average net investment. So let's say equals average. And I'll go and grab my net operating profit after tax. I'll take that average and divide by the average capital employed, which in this case is going to be net property plant and equipment over those four years. OK. Once I calculate that, that tells me-- and we'll get that formatted as a percent-- my return on invested capital is 20%. OK. So from a capital budgeting perspective we've now calculated four tools. Our NPV tells us that the project is generating more than a 10% rate of return, because it's earning a positive NPV of $47.37. The IRR tells me that I'm earning 14% on this project. That's above my 10% cost of capital. So both those capital budgeting tools would tell me to do the project. The payback tells me that the project is earning back its initial investment sometime during the third year. And from an accounting perspective I'm earning a return on invested capital of 20%. So we've tied together now our analysis of free cash flow with our capital budgeting tools. OK. So hopefully that ties together a lot of the lessons that we learn from week three back to the lessons that we learned in week two. Our measure of free cash flow is really our primary measure of whether value is being created inside the firm, and how much cash is getting created. We're going to use that measure of free cash flow to compute all the capital budgeting tools that we learned in week two-- net present value, IRR, payback, return on capital. Tying those two things together really gets us a long way down the road in terms of thinking about general valuation and general capital budgeting for any firm in different circumstances.
